Markets brace for more junk debt defaults

Monday 9 March 2009 20.01 EDT
First published on Monday 9 March 2009 20.01 EDT

Banks and insurance companies face more losses ahead as the global credit crunch bites into western economies, according to the latest measures of distress in financial markets.

The Markit iTraxx crossover index, which rates the market perception of the possibility of default among 50 European junk-rated borrowers, rose to a record 1169 basis points on Monday, ahead of the 1160 points reached last week.

The index was pushed by banks and insurance companies as they are exposed to plunging debt and equity markets.

Analysts fear banks will see more bad loans contaminate their books as well as further losses from their investments in complex debt vehicles and derivatives contracts. "Forward-looking indicators, such as spreads on credit default swaps [a product sold to protect against possible defaults], suggest that more pain is to come," said Gavan Nolan, an analyst at Markit, a financial data provider.

Credit default swaps (CDS) for Aviva, the insurer that stunned the market last week with a £1.3bn pre-tax loss for last year, rose 42 basis points to 425 basis points, while CDS on its rival Prudential was up 43 to 911 basis points, according to Markit.

A basis point on a credit default swap contract protecting $10m of debt from default for five years is equivalent to $1,000 a year.

Banks and financial institutions could face more bad news after the credit rating agency Moodys downgraded 17 collateralised loan obligations (CLOs), the complex debt vehicles at the heart of the credit crunch. CLOs bought mortgages or loans and sliced them into packages, reselling them to other investors, such as banks, without assessing the real risk of the underlying assets. Some mortgages were sold with the top AAA rating when they included sub-prime loans.

Banks will also see further losses as hundreds of European companies are expected to go bust this year.

The default rate among speculative-grade-rated European firms is forecast to soar to 22.5% by the end of this year, from 2.7% in February, Moodys said last week.

HBOS has already posted a £10bn loss, led by its exposure to bad loans. Like other traditional retail banks, it strayed into investment banking areas such as leveraged lending during the credit bubble.

From 2005 to 2007, HBOS' corporate lending leapt from £79bn to £109bn, backing deals including the £350m acquisition of the cinema chain Vue Entertainment.